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Preferreds Gain Attention as Fed on Pause

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Preferreds Gain Attention as Fed on Pause

Written by: Coulter Regal, CFA

With interest rates low and the Federal Reserve (Fed) set to stay on pause through year-end, income-focused investors are expanding their search for yield. One area that has attracted attention in recent months is the preferred securities category. Since the Fed first announced a pause on rate hikes towards the end of January, U.S. preferred stock ETFs have seen $1.4 billion worth of net flows.1 However, with a large percentage of the preferred securities’ allocations made up of banks and other traditional financial companies, investors may be missing opportunities for income in preferreds outside of financials.

The Current Market Environment Opens the Door for Preferreds

Since reaching a peak of 3.2% in November 2018, the yield on the U.S. 10 Year Treasury has fallen by over 70 basis points.As yields fall, income investors seeking the right mix of income producing assets may want to consider preferreds as a way to maintain income generation, while experiencing the potential for greater price stability than common stocks and more favorable tax treatment than bonds.

Preferreds have historically offered higher yields than both common stock and senior debt. Moreover, many pay qualified dividends, which are taxed at the capital gains rate rather than ordinary income, increasing the after-tax yield advantage of preferreds over traditional debt.

Yields Across Asset Classes
As of 4/30/2019Yields Across Asset Classes

Source: FactSet, Wells Fargo, Bloomberg. Yields presented are current yields (ratio of the annual interest payment and the security’s current price), except for Equities’ dividend yield (dividend per share, divided by the price per share). Equities is represented by the S&P 500® Index, High Grade Corporate Bonds represented by the ICE BofA Merrill Lynch US Corporate Index, Preferred Securities represented by the Wells Fargo® Hybrid and Preferred Securities Aggregate Index, and High Yield Bonds represented by the ICE BofA Merrill Lynch US High Yield Index.

Beyond higher yields, preferreds also have limited direct equity participation which may help minimize their volatility relative to common stock and help insulate investors from market drawdowns. Additionally, with the Fed’s pause on rate hikes extended through year-end and expectations of future hikes lowered, price volatility related to interest rate risk may stabilize.

Dialed Up Call Risk

Most preferred securities feature a call provision allowing an issuer to redeem its preferreds at or near par value prior to maturity. As rates fall, issuers may choose to call their preferreds and issue a new series at more favorable rates. This may potentially be problematic for investors on two fronts: it may reduce the yields available to investors, and many callable preferred securities may be trading above par value. In the latter scenario, capital appreciation may be erased in the event of a call. Preferred securities issued by traditional financial companies have historically been more often callable than those from other issuers. They also currently have more that are callable in the next two years and have more trading above their par value.

Lower Call Risk Outside of Traditional Financials
As of 4/30/2019

% Callable % Callable
Trading Above Par
% Callable
in 2019-2020
% Callable
in 2019-2020
Trading Above Par
Financial Preferred Securities 100.0% 87.9% 41.5% 33.0%
Ex-Financials Preferred Securities 77.8% 60.2% 25.5% 13.2%
Source: Bloomberg, Wells Fargo. Financial Preferred Securities represent the Wells Fargo® Hybrid & Preferred Securities Financial Index. Ex-Financials Preferred Securities represent the Wells Fargo® Hybrid & Preferred Securities ex Financials Index. For illustrative purposes only.

Related: How Is China’s Economy Doing?

Financial Sector Over-concentration

Preferred securities are predominantly issued by financial companies as they help satisfy regulatory requirements to support liabilities. This has led to an over-concentration in banks and other traditional financial companies which make up over 50% of the preferred securities universe. This over-concentration, particularly in low interest rate environments, may have negative implications for strategies that track the broad preferreds space, as the health and stability of financial companies may be more sensitive to interest rates than issuers in other sectors.

Sector Concentration in Preferred Securities
As of 4/30/2019Sector Concentration in Preferred Securities

Source: FactSet, Wells Fargo, Bloomberg. The broad Preferred Securities universe presented is represented by the Wells Fargo® Hybrid and Preferred Securities Aggregate Index. Preferreds Ex-Financials is represented by the Wells Fargo® Hybrid and Preferred Securities ex Financials Index.

Excluding preferred securities issued by traditional financial companies’ results in greater sector diversification, which has historically lowered volatility relative to the broad preferred universe without sacrificing yield.

The current market environment presents compelling reasons to consider preferred securities. Investors may gain thoughtful exposure to the space by avoiding traditional financial companies with the VanEck Vectors Preferred Securities ex Financials ETF, which tracks the Wells Fargo® Hybrid and Preferred Securities ex Financials Index.

Important Disclosures
1Source: Morningstar. Estimated net flows for US Preferred Stock ETFs for the months February 2019 through April 2019.
2Source: U.S. Department of The Treasury. https://www.treasury.gov/resource-center/data-chart-center/interest-rates.
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